The case was brought by a Colorado couple, Dean and Joanne Wandry. They owned a limited liability company called Norseman, worth about US$11 million in 2004. At that point they consulted a tax planning adviser on how to transfer shares in the business to their children and grandchildren without incurring gift tax. At the time, the federal lifetime gift tax exemption was US$1 million, plus US$11,000 per gift.

The difficulty with such transfers is that a closely held family business is often hard to value accurately. Even if the owner obtains a professional valuation at the time of the gift, the IRS will often challenge it later. So, if the owner gives away a fixed percentage of the company, which he calculates will fall within the gift tax exemption, the IRS may later decide that it exceeded the exemption. Then a tax charge of up to 35 per cent of the excess becomes payable.

The Wandrys avoided this by specifying the value of their gifts in cash terms. They made nine gifts adding up to a total value of US$1.099 million, which was within the exemption. The actual fraction of the company equity to be given away was left open in the transfer deed. It was to be calculated later, depending on whether the IRS accepted the Wandrys' own valuation of the business.

The IRS did indeed challenge the Wandrys' valuation, claiming that it was a 20 per cent underestimate. Moreover, it did not accept that the Wandrys could adjust the number of company shares transferred to their children so as to make the transfer again fall within the gift tax exemption. Accordingly it imposed a tax charge on the gifts.

The Wandrys appealed, and now the Federal Tax Court has upheld their appeal. The judge ruled that the couple intended to make a gift equal to their exemptions, so that they never actually transferred any more than that amount. Thus no tax was due on the gifts.

The decision allows tax-free transfers from one generation to another "with certainty and in an orderly manner", according to tax expert David Kautter. Previously the only certain way of avoiding an unexpected gift tax charge due to an IRS revaluation was to allocate the excess gift to a charity - a method that had its own drawbacks.

However, the IRS is not likely to be happy about the decision and may yet appeal it. Thus business owners who rely on Wandry to take advantage of the current US$5.12 million gift-tax exemption may be taking a risk.

Even if the IRS does not appeal, it may seek a change in the law to reverse the Wandry ruling - though not with retrospective effect.

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